Weathering Summer Days

The second quarter earnings season is all but over, and it was a fairly good one.  About two thirds of the companies reported beating earnings estimates, although these were somewhat reduced by analysts in the preceding months.  The market reaction to earnings news was definitely more benign than in the previous quarter.  Then, even the companies with solid performances registered, at best, minor gains or minor losses, and those that merely matched expectations or were guilty of slightly missing them were taken to the woodshed.  This time around, Mr. Market’s reaction to earnings report was a bit more sensible.

The market, meanwhile, managed to rise for five weeks in a row and is sitting near four months high.  The traders seem to have turned their attention to actual earnings, rather than the news from Europe.  Some positive economic reports here in the U.S., most notably more good news from the housing sector, also helped.  However, Europe is still far from resolving the debt crisis, and at some point scary headlines will return.  Some consolidation in the market in the near term is warranted.

As you know, I prefer to look past short-term fluctuations and to view quarterly results as a single step towards wealth-building goals.  There many companies out there with excellent fundamentals and prospects, even if they might be guilty of not exactly meeting analyst-estimated earnings targets.  Let us therefore concentrate on them, rather than on an economic headlines du jour.

Here We Go Again

The long-awaited pullback in equity prices that I alluded to in my previous post has finally arrived, and right on schedule, too!  The late spring and summer performance of stock market in 2010, 2011 and so far this year certainly gives credit to “Sell in May and Go Away” adherents.  Just like two years before, market woes this time around are once again caused by turmoil in Euro zone, specifically by recent Greek and to a lesser extent, French elections.

The victories of leftist parties in these countries put Germany-led continued austerity implementation in doubt.  However, the effectiveness of these policies over two-year old Euro zone crisis is dubious at best, as they only seem to push debt-ridden countries further into recession.  I am all for free market economy, but the question that many are asking is whether some stimulus should be in order.  Back home, I don’t think the results would be pretty if the response to our own mortgage crisis in 2008 was to start cutting benefits and raising taxes.

The only certainty is that situation is Europe will continue to be highly uncertain.  In fact, may observers place the likelihood of Greece exiting the euro as high as 75%, with other weak nations possibly following suit.  Adding to these fears is the slowing down of Chinese economy, although it is still expanding at a pace that any developed nation would be extremely happy with.  The Communist Chinese government runs their whole economy as one business, and they have shown that they are quite good at it, so “soft landing” there is a very good possibility.  Meanwhile, the U.S. economy continues to expand at a moderate rate and is one the brightest spots worldwide.

The just finished Q1 2011 earnings season confirms that view.  The S&P 500 earnings have now surpassed their peak in Q3 2007, but the prices are still down nearly 15% from that time.  Many excellent companies beat earnings estimates and increased forward guidance, but nevertheless stock prices suffered due to overall market malaise.  Moreover, earnings are expected to grow 17% annually in 2012.  It looks that this summer, like two summers before, will once again provide investors with excellent entry points.

No Love for Stocks. Great!

Stocks staged a powerful rally in 2012, with S&P 500 rising 10% year-to-date.  Yet most investors are not impressed.  After many years of high volatility and sideways markets, they continue to pull cash out of equities and putting it into bonds.  And I think this is great news for stocks.

According to a CNN Money article, “Retail investors are coming from an incredibly depressed mindset.  The only thing that will change that is a prolonged period of excellent performance in the equity market.”  Indeed.  You can rest assured that after such a prolonged period, after an average investor finally is excited about market prospects, then it would be time to get cautious.  I have personal evidence of this: I saw many people putting their money to work in the stock market in 2007, right near the top.  Of those, quite a few are choosing to pull out now, after five years of near-zero returns.

The fact that scepticism currently abounds is very comforting to me as an equity investor.  While a correction can happen at any time (in fact, one is probably overdue by now), such widespread caution is a sign that stocks have more room to run.  Indeed, even after a pretty good advance from the lows of last summer, stocks continue to be very reasonably priced, because earning have been also rising very strongly.

Finally, for a longer-term view, take a look at my post from last summer.  While we are currently still in the secular bear market (despite the recent rally), chances are that we are much closer to its end and ready for a rebound.

Market Update

2011 was a very difficult year to invest in the sense that in most cases, markets ignored company specific news and instead chose to focus on headlines coming from Europe. As I wrote previously, U.S. companies results and overall news from U.S. economy have generally been quite positive. This contrasted with fears of debt crisis in Europe spreading out of control. So we had this tug of war between these two forces in the markets, resulting in very high volatility and not much overall movement.

The upcoming earnings season will shed some light on the health of the U.S. companies. If the news continue to be good (and I think they will), absent any major headlines from Europe, stocks are likely to start reflecting their fundamentals and move higher. Indeed, this first week of the year was quite good. On the other hand, the specter of European debt issues will continue to haunt the markets for some time, so we can expect the volatility to continue. In this kind of environment, diversification and selecting the strongest companies will be critical.

Worst Quarter since 2009

As the title implies, the market performance this quarter was the poorest in nearly three years. Only Q4 of 2008 fared worse, and as you recall stocks hit a bottom soon thereafter in March 2009, and went on for a two year climb. There are several similarities between the situation now and back in 2008. Then, the markets were focused on the fallout from the banking crisis here in U.S. Now, it is a macro issue again, this time sovereign debt situation in Europe. On the valuation basis, stocks are now at the level of late 2008 – early 2009. An important difference is that balance sheets and company earnings are in incomparably better shape now than three years ago.

However, the markets don’t seem to pay attention to individual company performance lately. Even recent fairly positive economic reports from the U.S. – such as a solid manufacturing report, upward revision of GDP, and lower unemployment claims – have been ignored. Instead, the markets choose to focus on the possibility of Greek default. The situation in Europe is indeed uncertain and without a doubt can cause further market turmoil. In fact, most observes believe that Greece default in some form can not be avoided. Many economists also think that U.S. will enter (or already have entered) another recession and that it will have a negative effect on the currently stellar company earnings. In appears, therefore, that the market is already pricing in these outcomes.

Right now, the markets trade on fear and on uncertainty. As we gain more clarity into the macro issues, company fundamentals will once again drive company valuations. The coming earnings season will provide some insight going forward. I believe that combination of current extreme pessimism and 2008-like low valuations present an excellent buying opportunity for equity investors.

Market Update

“Listening and reading recent reports of mainstream media outlets could make one wonder if a new meltdown of the financial system is at hand. Headlines about double-dip recession, plummeting housing starts and consumer sentiment dominate the news. To be sure, latest batch of overall economic reports has not been stellar. Yesterday, markets dived after Fed Chairman Ben Bernanke said that the outlook for the economy was “unusually uncertain”. Really? Has it ever been unusually certain?

Right now, the earnings season is in full swing and company reports so far contradict doom and gloom. After many bellwether companies, such as Intel, Apple, Alcoa, Morgan Stanley, Caterpillar and others not only beat estimates, but offered higher guidance going forward, investors are finally beginning to take notice. Ultimately, it is only the earnings that drive the stock prices.”

The two paragraphs above are in quotes because they are taken verbatim from my shareholder letter at end of second quarter of 2010, exactly one year ago. The only difference is that Ben Bernanke this time around complained, “We don’t have a precise read on why this slower pace of growth is persisting”. Remarkably, worries about the state of economy and the markets are essentially unchanged — stagnant housing market, stubbornly high unemployment, and even debt crisis in Greece — were on investors’ mind one year ago as they are today. The markets took a similar path to last year as well; however, the decline this time around was not as severe as in 2010: then, peak-to-trough, S&P 500 dropped 16%, compared to only 8% this year (that is, of course, assuming that we have already found a bottom in this correction).

All that pessimism seemed to evaporate during the last week of the quarter, when it became clear that Greece will avoid default, at least for now, and after a surprisingly good report on manufacturing data was issued. As a result, the markets were able to recover and ended the quarter with minor losses.

It is said that bull markets climb the wall of worry. And we certainly have a long laundry list of worries, which hasn’t changed that much for a year. What did change, however, was the value of your portfolio, which increased by well over 30% in the last 12 months. So let us, as investors, not pay too much attention to media worry du jour, and instead concentrate on the companies that we actually invest in.

Dog Days of Summer

It certainly looks like the saying “Sell in May and Go Away” was a good call, just like it was a year ago.  Stocks fell for five consecutive weeks, but the total decline so far is only 6%, compared to 16% peak-to-trough drop last year.  At least for now, this is just a garden-variety pullback.

There was no dearth of  negative economic reports to justify this pullback.  Consider:

– The index of 20-city house prices fell below the level of 2009, which means that double-dip in housing market is here.

– Only 54,000 new jobs were created in May, much lower than expected.  The unemployment rate actually rose 0.1% to 9.1%.

– Manufacturing index fell to 53.4 (although a reading above 50 indicates growth)

– Consumer confidence index also fell, bringing it to the lowest level in 6 months.

– Leading investment banks, such as Goldman Sachs, lowered U.S. GDP forecasts.

As a result, investor sentiment turned decidedly bearish, which is quite a contrast to positive outlook just one month ago.  One might even wonder why the markets didn’t decline even more!

Despite the apparent slowdown, few economists believe that we are headed back to a recession; a new term — BBQ recovery — was even coined to describe the continuing recovery as low and slow.  The interest rates, as Fed Chairman Ben Bernanke stated on numerous occasions, will remain at current near-zero levels for an “extended period”.  Companies are using this opportunity to issue new debt at low interest rates to refinance their existing debt, buy back stock, or buy their competitors, all of which are long-term positives for the stock market.  In this interest rate environment, bonds are simply not competitive with stocks, and there are no other compelling alternatives to equities.

As we all know, company earnings ultimately drive the stock prices, and earning reports for a number of recent quarters were very strong.  So far, there were no negative pre-announcements; in fact, many companies reaffirmed their profit outlooks.  If Q2 earnings season shapes up similarly to several past quarters, this will help the markets to weather “dog days of summer”, consolidate and move forward.  The “Sell in May” crowd is correct so far, but in all likelihood they would have  missed a 30% gain from the low of correction last summer!

Market Update

The first quarter earnings reports are coming out in full swing, and as was the case for the last several quarters, they are strong.  So far, 75% of companies beat earnings forecasts, and only 14% missed them.  69% of all companies beat revenue forecasts.  The earnings were especially strong for high-tech companies, and these results propelled Nasdaq above its 2007 levels; it is now at 10-year high (but still more than 40% below its peak in 2000).  S&P 500 remains about 15% below it is 2007 pre-recession peak.

The U.S. dollar, meanwhile, is getting crushed.  I know, I just returned from a vacation in Italy.  A week ago, Standards & Poor issued a “negative” outlook on the U.S. credit rating, while keeping the AAA rating itself unchanged.  That didn’t help the dollar at all.  The clear beneficiaries of this are commodities which are priced in dollars, and multi-national companies whose dollar-denominated revenues increase as dollar weakens.  As I have such companies in my portfolio, I am not complaining — I am getting some help here to pay for that $8 cappuccino.

The most recent economic reports were moderately negative.  U.S. GDP growth was revised down to 1.8%, new jobless claims exceeded 400,000 for the second week, and home prices are dropping again, prompting more talk of a “double-dip” in the housing market.  I will of course be watching the forthcoming reports, but so far, I don’t see a big reason to worry — no economic recovery proceeds in a straight-line fashion, and setbacks are normal.

These temporary weakness in economic conditions and the fact that it is almost May makes many Wall Street observes to wonder whether they should “sell in May and go away”.  Indeed this “strategy” worked well last year: S&P 500 lost about 15% from May to July.  I am not a scholar of calendar anomalies, however.  In the end, stock prices are driven only by the earnings, and they have been consistently good.

Market Consolidation

It appears that the market consolidation that I have alluded to previously has finally arrived.  A number of world events in recent weeks has contributed to it:

• Unrest in the Middle East, particularly in Libya, and resulting rise in oil prices
• Earthquake and tsunami in Japan
• Unexpected Chinese trade deficit in February
• Downgrade of Greek and Spanish debt, and resulting resurfacing of PIIGS default fears

Despite these headwinds, the markets held up remarkably well, and are only down around 4% from the recent tops.  Given these events, and the fact that a pullback was overdue in any case, I am quite surprised that the downturn was not more severe.

The economic fundamentals, however, remain positive.  Corrections like this one are normal and healthy for the market.  The current pullback may well continue, but I believe it will be short-lived.  In April, the first quarter reports will start coming in, and should provide support for equity prices.

Gridlock is Good

In the movie “Wall Street”, ruthless tycoon Gordon Gekko famously stated, “Greed is Good!”  That may or may not be true, but I think that political gridlock is definitely good, both for businesses and for stock markets.  When politicians are busy bickering with each other, chances of new laws and regulations coming to play are diminished, and businesses are more likely to venture in new areas.   Uncertainty, the perennial enemy of a bull market, is reduced.  And  political gridlock is exactly what we have right now.

Markets are taking notice of this.  The European PIIGS woes are now all but forgotten, and even unrest in Egypt failed to derail the market.  In my earlier update, I called for a near-term market top.  So much for giving short-term predictions!

While I still think that a consolidation is likely, longer term uptrend remains intact.  Here are some points to support this point of view.

– Last week, two major milestones were retaken.  U.S. GDP finally advanced past previous pre-recession high of 2007.  Dow Jones also rose above 12,000 mark.  However, it still remains more than 14% below its previous peak reached in 2007.  Earnings yield, compared to bond yield, remains very attractive.

– There is a real possibility of a number of municipal bond defaults, and a downgrade of U.S. treasury securities.  While each of these events will be devastating for the bond market, ironically, the resulting redemptions from bond funds are likely to flow to equities, supporting stock market.  There are many people who, in the aftermath of the Great Recession, redirected their stock investments into bonds.  Slowly but surely, these investors are coming back to stocks.

– Cash continues to be a major holding on corporate balance sheets.  Sooner or later, it has to come into play, either in the form of stock buybacks, new hiring, investing the business, or mergers.  All of these are beneficial to the market. We are seeing some evidence of this already.

– Finally, last but not least, corporate earnings continue exceeding expectations.

In summary, there are many positives supporting the market now.  While bumps along the way are inevitable, current environment for equity investors appears to be quite good.